|Deal Economy Forecast|
So far, signs suggest that that might be the case. Sure, we're only a few weeks into the new year. But already some $124 billion in global deals has been announced, more than any year-to-date period since 2000, when global volume hit $217.9 billion, according to data provider Dealogic (Holdings) plc. A number of forecasters believe 2011 will outshine last year when global M&A volume grew 25%, to $2.7 trillion, over 2009 -- a slower pace than many had hoped, given economic improvements and the steady buildup of cash.
Bankers are particularly upbeat. "Our backlog has shifted dramatically from restructuring to M&A," says Rick Leaman, managing director at Moelis & Co. in New York and former chairman of UBS Investment Bank. "It feels like recoveries we've seen in the past. I've been through four crises. This one has had a more difficult recovery, but it's starting to feel like 2004-2005."
Despite the optimism, it's not clear how much of that cash will fuel this year's M&A activity, or whether that surge of deals in early January means anything. All that cash has a shadowy complement: debt, and lots of it. Last year, the bulk of money raised through new bond issues and loans went either to refinance debt or to fund general needs. And looking out, there's plenty more to refinance as the backlog of debt maturities looms. For instance, consulting firm Deloitte LLP estimates that there's nearly $11.5 trillion of debt across the largest 9,000 companies in the G-20 that must be rolled over in the next five years.
|Corporate cash is on the rise -- and so is debt|
|Year||Total financial assets ($B)||Debt* ($B)||Total cash* ($B)||Debt %||Cash %|
*Cash and debt are a percent of total financial assets
Source: Federal Reserve (Data is for nonfarm nonfinancial corporate businesses)
That necessity could easily slam head-on into tighter refinancing markets and changes in accounting rules. "The refinancing bubble could be occurring around the same time many large U.S. corporations will be converting their standard of financial reporting from U.S. generally accepted accounting principles to International Financial Reporting Standards, says Sandy Cockrell, managing partner of Deloitte's Chief Financial Officer Program in New York. "There could be a perfect storm brewing for these companies. As the impending refinancing wall comes, traditional covenants and public debt will likely be tighter than precrisis." He anticipates that many companies may have to use a portion of their offshore cash balances for refinancings. In other words, some of that big cash pile will have to go to pay down debt, not to engage in M&A.
For many companies, a large practical problem exists in getting their hands on that cash. Although there are no central statistics that pinpoint exactly where this cash resides, accountants and bankers say the majority of the $1.9 trillion is stashed in overseas subsidiaries of U.S. companies. An estimated 50% of S&P 500 companies generate revenue overseas, and most have no interest in paying the 39.21% U.S. corporate tax rate on repatriated cash, a rate that could soon be the highest among developed nations if Japan follows through on plans to cut its rate by 5 percentage points, from 39.54%. "Multinationals in the U.S. have a significant amount of cash sitting offshore. Those companies that have strong balance sheets don't need to pay the tax to bring it back to refinance -- they'll leave it offshore," says Dan Lange, a managing partner in Deloitte's tax group. "Given the choice, companies will choose not to pay that tax."
Although President Obama is considering backing a cut in the corporate tax rate, that remains a wild card for this year. Indeed, it's not clear that CEOs are ready just yet to blow through their cash, considering that they still face considerable uncertainties on the regulatory, sovereign and municipal debt and domestic economic fronts. Also, while corporate America is clearly on the mend, memories of the crisis remain raw. Analysts say, for instance, that General Electric Co. chief financial officer Keith Sherin has spoken bluntly about how badly GE underestimated systemic risk leading up to 2008 and has sworn to do a better job managing liquidity risk for the future.
So while companies like GE have begun wading back into M&A -- in October GE announced it would buy natural gas equipment maker Dresser Inc. for $3 billion -- many others may continue to squirrel away cash. Indeed, many can still do both. In 2008, GE had $16 billion in cash. Today it's sitting on some $78 billion, making the Dresser deal look like pocket money. "GE was highly leveraged and had to cut its dividend," says a GE lawyer. "Keith Sherin won't ever cut that dividend again. He's going to make sure he's getting the balance sheet to where it needs to be." In 2010, GE hiked its dividend to 14 cents a share from 10 cents, though that's still less than half the 31 cents shareholders were getting before GE slashed the dividend in 2009.
Other companies face similar pressures. A closer look at corporate balance sheets suggests that beneath the cash, which, based on Federal Reserve data, jumped from $1.79 trillion at year-end 2009 to $1.93 trillion in the third quarter of 2010, corporate debt has also been edging higher. At the end of the third quarter, debt as a percentage of total financial assets stood at 52.4%. With the exception of 2008, when that measure hit 54%, relative debt levels are the highest they've been since 1998, when debt as a percentage of assets was 56% and cash levels a more modest 10.9%.
|Focus has been on balance sheet repair|
|Investment-grade bond and loan issuance for 2010:||$1.4 trillion|
|Bond issuance:||$792 billion|
|Loan issuance:||$610 billion|
|Sources: Dealogic, Bank of America Merrill Lynch|
This suggests that corporate balance sheet repair is not finished yet. Moreover, the wall of debt maturities that was expected to create default mayhem two years ago, only to fade away, is beginning to loom again as the days of amending and extending debt terms run out. Analysts and fund managers expect debt repayment schedules to accelerate this year and through 2015. Standard & Poor's projected earlier last year that there will be $447 billion in total investment-grade debt coming due through 2011 and a further $120.3 billion in high-yield bonds.
While the ratings agency sees investment-grade maturities peaking in 2012 at $526 billion, high-yield maturities will continue to grow, topping out in 2014 at $380 billion. Analysts at Mudrick Capital Management LP, a New York-based investment management firm that buys distressed debt, say there could be $150 billion to $250 billion of high-yield and levered loan defaults coming. Many of these are private equity deals where leverage ratios have ballooned. According to Mudrick Capital, 928 leveraged buyouts with enterprise values of $1 billion or more were completed between 2006 and 2008 in the U.S. for a total of $1.166 trillion. Since then, leverage multiples for many of these companies have jumped from around 7 times to 10 times or more cash flow.
"There are going to be a lot of defaults over the next five years due to the excessive leverage multiples of the precrisis LBOs," says Jason Mudrick, the firm's president and chief investment officer. "If interest rates move higher, it's going to be harder for companies on the margin to survive." It will be even more difficult because Ebitda for both investment-grade and non-investment-grade companies has plunged 30% to 40% since the 2007-2008 peak. That makes debt all the more expensive to carry on balance sheets. Those with double-digit leverage multiples are most vulnerable.
"These aren't likely to be refinanced, and if they are, they aren't going to get refinanced at LIBOR plus 200, but more like LIBOR plus 1,000 basis points. They do not generate enough cash flow to support this cost of capital," Mudrick warns. He notes that there is a roster of high-profile sponsor-backed companies facing the debt wall, including Freescale Semiconductor Inc., First Data Corp., MGM Resorts International and Clear Channel Communications Inc. MGM Resorts is just one of many that assumed a truckload of debt during the downturn -- some $13 billion in long-term debt. The company has said repaying the debt is a top priority as due dates loom. And while other companies in a similar situation may find ways to repair their balance sheets or improve their businesses, the clock is ticking.
"We're starting to see a bifurcation between healthy companies and those that aren't," says Deloitte's Cockrell. "The larger investment-grade credits have little concern today on traditional liquidity risk over the next three years because they have strong access to credit." But it's a different story, he notes, for non-investment-grade corporates, which, suggests colleague Ajit Kambil, global research director of Deloitte's CFO Program, could present opportunities for healthier companies. "This is an opportunity for the big to get bigger. They can go out and swallow the minnows." Kambil points to opportunities in sectors that already have lots of debt, such as industrials, consumer products and retail.
Still, 2011 could prove to be a difficult balancing act for CEOs confronting shareholder demands to amp up returns in markets still thought to be bristling with risk. Even bankers optimistic about the M&A outlook observe caution among CEOs and their deal teams. Jeffrey Kaplan, global head of M&A at Bank of America Merrill Lynch, says the M&A environment is "more conservative" than two to three years ago when it comes to risk. While he expects a healthy pickup this year, he believes deals will be more conservatively structured than in the past. "Over the past six months, we've seen a strong return of M&A based on a greater risk-return and tolerance model. In the current environment, we expect to see better-capitalized deals, lower cost of funding and greater equity." Companies will remain conservative, he says, and "will not pursue M&A if there is too much risk on their balance sheets."
Leaman agrees, saying dealmakers are in no mood to imperil credit ratings again. "In today's environment, a company's pro forma credit rating is a critical part of any transaction analysis," he says. "Precrisis, companies underappreciated the value of a good credit rating because they weren't being penalized as much as they should have been for taking on too much leverage."
Sometimes fear can be a good thing. CEOs worried about their credit ratings or wary about new crises may feel more inclined to hold on to some of that excess cash, even at the risk of shareholder unhappiness. According to a recent industrywide survey on corporate risk practices, it looks as if CEOs may end up needing that extra cash buffer if markets hit another bad patch, based on what seem to be clear deficiencies in the way companies account for risk. In December, the Committee of Sponsoring Organizations, a group that provides research and analysis on enterprise risk management, also known as "the systemic view of risk," published a survey that showed that 60% of 460 companies admitted that their risk management processes were still ad hoc. Nearly half described their processes as "very immature" or "somewhat immature," and 35% said they were not comfortable with the way they reported key risk indicators to senior executives.
"I think there's overconfidence [among companies] in what they think their risk management process is doing for them," says Mark Beasley, Deloitte professor of enterprise risk management, ERM initiative director and accounting professor at North Carolina State University. Beasley, who helped conduct the COSO study, says many companies lack a forward-looking strategic risk process. For the most part, CEOs tend to use a "very gut and ad hoc way" to pinpoint risks. "The surprise for me has been the lack of sophistication in really linking their risk thinking to their strategic thinking," Beasley says of senior executive teams he's worked with.
While the study mostly found gaps in practices of smaller companies, Beasley and others suggest larger companies may rank themselves higher than warranted. Consultants say conversations with CEOs and their executive teams can often expose discrepancies in views about the company's greatest future risks. In reality, most companies, even the more sophisticated, have only just begun to tackle the way they manage the kind of systemic risks that shredded corporate balance sheets in 2008.
Analysts say GE, for instance, only started to manage enterprise and liquidity risk across all of its business groups in the past year or two. Before 2008, the company relied heavily on its strong credit ratings and downplayed broader, external risks. Among other problems, analysts say, the company grossly underestimated the impact of the real estate collapse. Analysts say it stress-tested for a 15% decline in that asset class, when in fact there was a 45% loss. Others have similarly been building out their enterprise risk management models over the past year, including Target Corp. and H.J. Heinz Co., which have developed formal systems to quantify emerging risks now embedded in senior management, Beasley says.
Better risk and liquidity tools could prove important as M&A picks up and competition increases. "As companies start to emerge from recession, capital spending and buybacks are going back up," says John Puchalla, a senior analyst at Moody's Investors Service in New York. "I would hope liquidity management would still play a big part, but my sense is that the pendulum is swinging back to growth initiatives. We're still more conservative than in 2007, but not quite as conservative as we were more recently."
Perhaps for now, CEOs still feeling skittish may try to limit their zeal for leverage and take their time spending some of that cash on M&A. Bankers say memories of 2008 have helped redefine M&A strategies and the kind of deals getting done right now.
"The risk aversion in the current market is characterized by M&A deals not getting executed," Kaplan says. "Successful deals are strategic, vertical and synergistic. There is not a lot of new business diversification in M&A, as shareholders do not have patience for deals that are not well conceived."
In the year ahead, companies will have to balance the need to target deals more strategically with pressure to generate higher returns. Even if CEOs can't get at all the cash sitting overseas, they must contend with the public perception that it's at their fingertips to spend. This year, a little patience could be worth a lot in excess cash.